Supermarkets are likely to be one of the sectors hit hardest by the new National Living Wage to be launched in April 2016. This is because wages account for a relatively high percentage of their cost base. We estimate Morrisons, Tesco and Sainsbury’s have a combined UK wage base of over £8 billion. A fair proportion of their employees is paid either the NLW, or close to it. Even if wages rise at only four per cent per annum they face a £320 million headwind per annum.

Moreover, intense pressure from discount chains, such as Aldi and Lidl, limits the supermarkets’ ability to raise prices. Indeed, you only have to turn on the TV to see supermarkets advertising their price credentials. Morrisons, for example, has adopted a “love it cheaper” strategy. It is not alone. All the major supermarkets are devoting considerable resources to cutting prices.

Engaging in a price war while paying higher wages presents obvious challenges to supermarkets. The big food retailers are already operating on wafer-thin margins as they fight the dual threat from online groceries and the discounters. Margins will not return to their previous levels in the near future. The new entrants - Aldi, Lidl and Ocado - are prepared to win market share by accepting returns on capital below those of the rest of the industry. As a result, the new normal for margins and the industry's overall profitability will be considerably lower for longer.

Cut-throat competition

Food retailing has always been a savagely competitive sector. Household names such as Somerfield, Safeway, Bejam and Kwik Save among others have vanished in the past 20 years. History shows no company has a divine right to maintain its market share. Custom is earned through a combination of quality products, competitive pricing, excellent customer service and a highly efficient distribution system. Falling short in one of these categories for any length of time always ends in a painful resetting of margins and costs, as Tesco and Morrison can testify.

The inexorable rise of the discounters

Yet the sector has become even more cut throat recently. Aldi and Lidl have seen their joint share of the groceries market double to ten per cent in just three years, according to figures released by Kantar Worldpanel in November 2015. Sainsbury's was the only one of the `big four` supermarket chains to increase sales and market share.

The discounters offer a smaller selection of goods than the major supermarkets, and the majority of products are own-label. It is the combination of quality goods at attractive prices that has been the key factor drawing customers to their stores. Aldi and Lidl started trading in the UK over 20 years ago, yet it was when the quality of their own-brand products improved markedly that market share gains accelerated. Both companies regularly win taste awards, and any stigma that once existed among consumers in shopping at Aldi or Lidl has long passed. The success of Aldi’s “Like brands, only cheaper” and Lidl’s “Shop a Lidl Smarter" advertising campaigns highlight how far they have come.

As privately-owned entities, neither Aldi nor Lidl need answer to public shareholders. They have a strong ethos of reinvesting gains back into lowering in-store prices. They also take a longer-term view on investment returns than their quoted competitors and are willing to accept a lower return on their overall investment. Consequently, they pose a fiercely disruptive threat to the whole industry.

The supermarket majors have cut prices and boosted in-store employee levels to improve service as they strive to stem the flow of customers to the discounters. But both developments have had a negative impact on margins and profitability. The discounters 10 per cent share of the UK market remains well below the 15 per cent share they have gained in much of Europe. Recent market research by Kantar confirms that the pace of the discounters’ advance shows no sign of slowing. So we expect the discounters to continue pressuring industry margins for years to come.

The online shopping threat

The rise of the online retailer Ocado is the other major threat to the big four supermarkets. Ocado’s key advantage lies in the fact that it is more efficient for a pure online food retailer to automate the selection of groceries in huge mechanised warehouses than it is for the mainstream supermarkets. The latter’s online grocery sales mainly rely on dedicated staff selecting goods from store shelves. They face increased distribution costs and investment in IT infrastructure, while the online offer undermines in-store sales. The result is further pressure on margins.

These developments could have been foreseen, partly at least, at any time since the start of this decade. But too often, the market’s forward-looking radar scans no more than 6 or sometimes 12 months ahead and misses such threats – and opportunities – entirely.

When we visit companies, we focus on identifying the threats and the opportunities facing businesses over the next three to five years, rather than the short term. The threat posed by Aldi, Lidl and Ocado has been clear for the past four or five years, and we anticipate that their expansion will continue for years to come.

An extra concern for the industry is that Amazon is joining Ocado in offering online sales via Amazon Pantry. A well-funded competitor like Amazon, which prides itself on not making money, poses a significant threat.

False hopes?

The key question is whether margins can recover, possibly to pre-2010 highs. Many analysts and value-focused funds have highlighted previous recoveries in the UK supermarket sector, such as between 2004 and 2006, or the more recent renaissance of Carrefour, the leading grocery retailer in France. However, we believe idiosyncratic factors played a key role in these cases. The revival in 2004 to 2006, for example, reflected Morrisons’ takeover of Safeway. Moreover, the supermarkets today face industry-wide challenges rather than individual issues. In terms of Carrefour, the discounters Aldi and Lidl and the online player Ocado are much less of a threat in France than in the UK. The experience of Germany is more relevant. There, the discounters have a significant market share and industry margins have remained amongst the lowest in Europe for a long period with no sign of recovery.

In conclusion, the challenges facing the big four supermarkets are likely to intensify in 2016. The discounters will continue to make inroads into their market share. Meanwhile, the online threat is likely to intensify as Amazon joins Ocado in this sector. Adding to the supermarket’s woes, the new National Living Wage, to be introduced in April, will add significantly to their cost base. Thanks to the discounters and online competition, the food retailing sector will eventually resurface in more efficient form. But it is likely to prove a bumpy journey.

Important information

Unless stated otherwise, any sources of all information is Aviva Investors Global Services “Aviva Investors”) Limited as at 21 December 2015. Unless stated otherwise any views and opinions expressed are those of the author and should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA15/0897/310316

Simon Young

Senior Fund Manager

Main responsibilities

Simon manages retail UK equity funds.

Experience and qualifications

Simon joined Aviva Investors from BlackRock Investment Management where he was responsible for managing UK equity and UK income portfolios for institutional and charity clients.
Simon holds an MA in Geography from Pembroke College, Cambridge and is a CFA charterholder.